Tenjin AI Predicts Macro Environment Poised to Benefit Financials, Communications, Consumer Cyclicals
Authors: J.T. Culp and Sivanand Birusumanti, Andrew Qiao, and Jerry Yuan
Summary:
- To best capture overall growth prospects in the current macroeconomic climate, TenjinAi recommends the following ETFs which scored very highly in its proprietary AI-based rankings: FINX, VFH, XLF, KBWB, XLC, VOX, RCD, VCR, and XLY.
- Multiple macroeconomic factors and trends will allow the Financials sector to outperform the broader market. Banks’ margins will benefit from larger spreads due to the anticipated interest rate rise.
- Higher rates of consumption, driven by pent-up demand from the pandemic, will also benefit digital payment companies.
- If high inflation persists, companies with pricing power are positioned to pass on costs to customers. If inflation is transitory, consumer cyclical that had underperformed YTD could take off.
- The falling unemployment rate will be another catalyst that drives spending and consumption of goods.
- Communications give investors exposure to various growing industries in gaming, social media, streaming, and big tech. With a majority of holdings in low beta stocks, Communications ETFs have limited volatility.
Financials Strongly Positioned to Lead
In light of recent inflationary concerns, the Federal Reserve indicated that they could raise interest rates twice by 2024, with the first hike potentially coming in 2022. If these increases materialize, financial stocks will likely be the prime beneficiary, as they historically perform well during periods where the Federal Funds Rate increased.
Specifically, banks perform well during periods of rising interest rates. Higher rates allow for margin growth as bank spreads expand during these periods. In other words, banks’ profits increase due to extra income generated from the higher rates charged on long-term loans. This is one catalyst that could drive the already attractive Financials sector, which trades just above their multiples from late 2007.
Banks did hit turbulence last week after an initial gain following the Fed announcement. This was due to concerns regarding the future appetite for loans, as balances have dwindled for retail banks YoY, and the continued flattening of the yield curve. The chart to the left shows the XLF Financials ETF graphed against an index that tracks the slope of the yield curve. Typically after the slope falls for an extended period, so do companies that rely on loans. Banks aim to borrow in the short term and lend over the long term, so the tightening of this spread poses threats to profitability. Some potential catalysts could push banks like BAC, JPM, C, and WFC higher in the near future, as all 23 banks passed the Fed’s stress test on Thursday, which will end COVID-era restrictions on dividends and buybacks. As a result, Piper Sandler expects dividends to grow 7.6% this year, and for firms to buy back 6.4% of shares outstanding. With this in mind, the recent pullback could allow banks to buy back shares at a lower cost and raise dividend yields at the time of announcement.
Bank stocks will not be the only beneficiary during the recovery of a decade-plus expansion post-pandemic. Credit Card and digital payment stocks including MA, V, AMEX, PYPL, and SQ have considerable upside as a result of rapid growth in consumer spending. Spending is back on track from its pre-pandemic trend, driving 7% expected GDP growth in 2021, and is expected to continue to be the force behind 3.5% growth in 2022.
Visa and Mastercard will benefit from global spending growth through credit card fees. PayPal, Square, and banks will enjoy growth in P2P (Peer-to-Peer) payments through Venmo, Cash App, and Zelle as well as through fees received from businesses that use their services to accept payments. Despite both only operating in the U.S., PayPal believes Venmo can generate 10x revenues by 2025, while Cash App’s revenue jumped ~440% in 2020 and increased 665% in Q1 YoY. Both apps have also begun to accept and transfer cryptocurrencies, and interest has been strong. Cash App had over 3M users make their first crypto transactions in 2020, and another million in Q1 2021. These apps are also evolving past just digital wallets, as both have allowed users to accept direct deposits and use debit cards connected to their accounts.
Depending on what specific area of financials investors are more bullish on, they can buy some of the aforementioned companies or concentrated ETFs. TPAY and FINX (Tenjin Score†: 4.84/5) focus more on the fintech side, whereas more traditional financials funds like VFH (Tenjin Score: 4.88/5), XLF (Tenjin Score: 4.89/5), and KBWB (Tenjin Score: 4.65/5) are more concentrated in retail banks. If you’re looking for dual exposure, JHMF is a great pick.
Weathering Inflation
Inflation is potentially the largest risk to financial markets at the moment; it can erode consumer purchasing power, pressure producers’ bottom lines, and cause the Federal Reserve to raise interest rates. With inflation data, such as the Consumer Price Index (CPI), coming in higher than expected in recent months investors are beginning to wonder if this upward pressure on prices will persist in the long term or remain transitory. In his press conference last week, Federal Reserve chairman Jerome Powell said he expects prices to act similarly to many commodities like lumber, consisting of short-term run ups before a crash to around previous levels.
If the Fed is correct and inflation hovers closer to its long-term target, consumer discretionary stocks that have underperformed the market YTD could be cleared for takeoff. If costs for producers return to pre-pandemic levels by the end of the year, companies that operate in competitive industries with many substitutes won’t have to worry about their margins being squeezed while taking a large hit to their bottom line. Data from Bloomberg shows the historical inverse relationship between the Producer Price Index, which measures inflation from the perspective of consumers, and the consumer discretionary SPDR ETF, XLY.
The two typically moved contrary to each other in the decade plus prior to 2020, with stocks making strong gains in periods where the PPI dropped.
Another catalyst for growth in the sector is the growth in consumption mentioned above. The lack of ability to travel or go out and cancellation of events such as weddings and concerts caused unbelievable levels of pent-up demand that is starting to materialize. Consumers are returning to restaurants, sporting events, and other attractions as restrictions ease in many countries. With vaccination rates rising, people are also going on vacation again, with passengers at TSA checkpoints having risen at an exponential rate this year and cruises are beginning to set sail again. Continued job gains, and a lower unemployment rate, will also stimulate spending in the long run. With more people entering the workforce again and earning a sustainable wage/salary, spending should rise with employment, as they have historically. The Fed’s targets for 2021 and 2022 are 4.5 and 3.5%, indicating that employment levels could return to near 2019 levels soon. Because of these trends and historical outcomes, we recommend that investors invest in positions such as RCD (Tenjin Score: 4.91/5), VCR (Tenjin Score: 4.96/5), and XLY (Tenjin Score: 4.78/5), although be aware VCR and XLY are value-weighted and hold considerably more TSLA.
In the case inflation persists long-term, large companies with strong, loyal customer bases will provide investors protection. Large-cap stocks like Apple, Microsoft, Nike, and Adobe have strong moats and pricing power that will allow them to pass on higher costs to consumers without seeing a significant decline in sales. Investors could also look into commodities like gold, oil-linked energy companies, and materials stocks as they all have historically performed well in periods of high inflation. TIPS (Treasury Inflation Protected Security) is another hedge where the bond’s principal increases with inflation.
Communications Offers Investors Unique Exposure
The telecommunications sector holds immense growth potential and opportunities given the significant spike in social media, gaming, streaming, and internet usage during the pandemic. Over the next decade, services such as 5G, streaming, and gaming are well-positioned to enhance user information, grow their audiences, and further engage users. In the coming years, billions of people worldwide are set to acquire access to the internet, allowing tech giants like Google and Facebook to capitalize alongside those in the industries mentioned above.
Streaming service usage has significantly increased through the pandemic, to the extent that the United States now has more streaming subscriptions than people as of Q1 2021, with the average consumer subscribing to multiple services as they maximize the content they consume. Most new users signed up with industry leaders such as Netflix (NFLX), Amazon Prime Video (AMZN), and Disney+ (DIS). It is worth noting that 3 million of the new users had never subscribed to any service previously. These companies are also making massive investments in expanding their content. Amazon recently acquired studio MGM for $8.45B, Netflix will spend over $17B on original content this year (up from $11.7B in 2020), and Disney+ continues to develop countless new shows within its many franchises including Marvel and Star Wars.
Along with streaming, social media platforms have experienced considerable growth as a result of the COVID-19 pandemic. 316M new users joined social media platforms in 2020. Facebook (FB), YouTube (GOOG), Snapchat (SNAP), and Twitter (TWTR) have immensely benefited from the increase in social media consumption. We expect these users to be sticky given the nature of social media. Unlike streaming or gaming, there is relatively little risk of a drop in retention because whether or not users are home or not, these services are always at their fingertips or in their pockets. Many apps and sites, similar to gaming and streaming, are also meant to addict users and keep them engaged as long as possible.
Given they can retain these new users, these companies can capitalize on the higher-priced ads their platforms drew during the pandemic. In Q1, Facebook saw the costs of advertising on Instagram and Facebook rise 60% YoY, indicating that companies are paying a premium to promote themselves online even as vaccinations rise. Demand should continue to rise in the long term as the number of people globally with internet access continues to expand and interact online.
Gaming took advantage of the stay-at-home environment, with gamers playing longer and more often, to the tune of a 35% uptick YoY in 2020. Streaming of video games also was a major growth area, with 8.8B hours of content streamed last year, up nearly 80% YoY. 6.3B of these hours were on Amazon’s Twitch, while the other 2.5B were on YouTube and Facebook live videos. Capitalizing on new advertising opportunities has been another focus for companies, with Facebook being a key example, as they have introduced ads within its Oculus headset, the leader in the virtual reality gaming space.
Not only do ETFs like XLC (Tenjin Score: 4.99/5) and VOX (Tenjin Score: 4.99/5) give investors exposure to all the industries above, but they also limit their volatility and downside risk by including telecom companies with predictable revenues and low betas. Verizon, AT&T, T-Mobile, and Charter also have exposure to 5G, which should allow them to see top-line growth given both businesses and households are expected to upgrade their internet speeds and bandwidth to adjust to the demands of a post-pandemic world. The largest holdings of these ETFs are Google and Facebook, comprising around 40–50% of their respective funds. Although this may seem high, these are both great companies with links to nearly all the aforementioned trends. Facebook owns Instagram, WhatsApp, Messenger, as well as having live-streaming capabilities. Google owns YouTube, which has billions of users and also allows for live streams. Both of these giants make a majority of their revenue from advertising, so an ever-growing number of internet users and the rising popularity of their subsidiaries show a bright future of growth for both.
† Tenjin scores refer to Tenjin AI Financial Technologies’ proprietary AI-based model that scores and ranks various high-quality ETFs and Stocks from a multitude of factors on a weekly basis.
